Profitability ratios

Profitability ratios help in the analysis of the combined impact of liquidity ratios, asset management ratios, and debt management ratios on the operating performance of a firm.

Consider the following scenario:

Your boss has asked you to calculate the profitability ratios of Cute Camel Woodcraft Company and make comments on its second-year performance as compared to its first-year performance.

The following shows Cute Camels income statement for the last two years. The company had assets of $11,750,000 in the first year and $18,796,000 in the second year. Common equity was equal to $6,250,000 in the first year, 100% of earnings were paid out as dividends in the first year, and the firm did not issue new stock in the second year.

Cute Camel Woodcraft Company
Income Statement For the Year Ending December 31	Year 2	Year 1
Net Sales	$6,350,000	$5,000,000
Operating costs less depreciation and amortization	1,610,000	1,495,000
Depreciation and amortization	$317,500	$200,000
Total Operating Costs	1,927,500	1,695,000
Operating Income (or EBIT)	$4,422,500	$3,305,000
Less: Interest	442,250	264,400
Earnings before taxes (EBT)	$3,980,250	$3,040,600
Less: Taxes (40%)	1,592,100	1,216,240
Net Income	$2,388,150	$1,824,360

Calculate the profitability ratios of Cute Camel Woodcraft Company in the following table. Convert all calculations to a percentage rounded to two decimal places.

Ratio		Value
	Year 2	Year 1
Operating profit margin		66.10%
Net profit margin	37.61%
Return on total assets		15.53%
Return on common equity		29.19%

Decision makers and analysts look deeply into profitability ratios to identify trends in a companys profitability. Profitability ratios give insights into both the survivability of a company and the benefits that shareholders receive. Identify which of the following statements are true about profitability ratios. Check all that apply.

If a company has a net profit margin of 10%, it means that the company earned a net income of $0.10 for each dollar of sales.

If a companys operating margin increases but its profit margin decreases, it could mean that the company paid more in interest or taxes.

An increase in the return on assets ratio implies an increase in the assets a firm owns.

If a company issues new common shares but its net income does not increase, return on common equity will increase.